In the wake of the Great Recession, China’s debt-fueled stimulus investments pushed its economy into double digit growth rates while the rest of the world struggled to get back on its feet. However, it has become clear that this credit led growth did not come without consequences, as debt levels in the country have risen from 130% of GDP in 2008 to 210% in 2013. In particular, the shadow banking sector in China, which is estimated by JP Morgan to have swollen to over 6 trillion USD, has recently caught the attention of international investors and market watchers, some of whom have drawn parallels to the United States’ subprime mortgage crisis in 2008.
Shadow banking, a term which encompasses a broad range of high-risk transactions taking place outside the formal balance sheets of traditional banks, has become pervasive throughout China, as state-owned banks that dominate regulated financial activity in the country lend primarily to state owned enterprises and local governments. This leads small to medium enterprises (SMEs), whose activity comprises 60% of China’s GDP and who do not have access to credit from state-owned banks, to rely on a system of informal and unregulated lenders in order to finance their activities. This credit is often supplied by investors willing to put their money into high return wealth management products, as the People’s Bank of China, the country’s central bank, restricts interest rates on traditional deposit accounts to abnormally low levels.
Growth in Discrepancy between Formal Loans and Total Credit in China
While this informal activity may drive growth within the Chinese economy, the unregulated nature of these transactions can lead to excessive speculation. Until recently, Chinese policymakers, aware of their system’s own financial inadequacies and dependent on the growth of SMEs, have turned a blind eye towards the growth of shadow banking.
Observers have speculated for some time that China’s shadow banking sector is a legitimate risk to the country’s economic well-being. These concerns were realized in January when a dubious trust fund, Credit Equals Gold No. 1, nearly defaulted on a 3 trillion RMB loan made to coal company Shanxi Xhenfu Energy Group. At the last moment, the trust was bailed out by unknown sources (speculated by some to be the Shanxi local government). This near default may only be the tip of the iceberg for toxic shadow banking loans. Bernstein Research expects that more than 40% of similar trust-based products, which account for a significant portion of informal banking in China, are set to mature in 2014.
The deepest concern about shadow banking is the connections between wealth management funds and loans originating from China’s state run banks. This produces systemic vulnerability to defaults in the shadow banking sector. In the worst-case scenario, a series of defaults could spark a credit crisis and severe economic slowdown in China that would send ripples throughout an already teetering global economy.
Chinese policymakers are cognizant of the dangers that shadow banking poses and have moved to curtail risky informal lending, including a mass crackdown in 2013 of over 1400 illegal lenders. Yet, their policy options are constrained; with China already facing reduced GDP growth rates, any attempt to significantly overhaul the shadow banking sector could lead to a financial panic that further exacerbates decline in growth.
Taking into account the fact that China’s state-owned banks are underwritten by a government that has the world’s largest trade surplus, total control over cross-border capital flows and $3.5 trillion in foreign exchange reserves, the threats of default to the world’s second largest economy may not carry the same risk as did US subprime mortgage loans in 2008. Nonetheless, in coming months Chinese policymakers face a delicate balancing act: reducing the systemic risks arising from an out-of-control shadow banking sector while also maintaining high levels of growth to ensure political stability.
For those interested in reading more about shadow banking, and the overall state of China’s financial system:
2013 Report to Congress: Chapter 1; Section 3: Governance and Accountability in China’s Financial System. The U.S.-China Security and Economic Review Commission. November 2013
Kai Yan, Douglas Elliot. The Chinese Financial System: An Introduction and Overview. Brookings Institute. July, 2013.